Felix Salmon at Market Movers frames an “inevitable” question: would financial markets be in their current parlous state if Lehman had been bailed out?
I don’t buy it. Hank Paulson has been working on his RTC II plan for months now, quietly; if Lehman hand’t precipitated its need, then something else would have, unless the Treasury stepped in to rescue every financial institution which looked like it might fail.
It’s even possible that Lehman wasn’t the immediate cause of the crisis, and that a Lehman bailout would have been followed in swift succession by an AIG bailout, a Morgan Stanley bailout, and, not long after that, RTC II.
Salmon is right in saying that bailing out Lehman would not have been a resolution to the fundamental problems underpinning Wall Street’s troubles, but a bailout probably would have avoided the events of last week. And possibly also the need for an RTC II altogether.
Lehman’s collapse - like Bear Stearns’ collapse - wasn’t triggered directly by big writedowns on mortgage securities. It was triggered by a slow erosion of confidence that reached its tipping point on Friday 12th September. A point was reached where it didn’t actually matter what the fundamentals of Lehman’s business were, but where clients and creditors were caught in a classic prisoner’s dilemma: everyone feared what everyone else was thinking. The optimal solution was just to cut and run, nevermind altruism.
When Lehman did go under, it was a shock. The CDS on Morgan Stanley and Goldman Sachs were already trading wide, but LEH’s collapse sent them rocketing. There was suddenly a realisation that the Treasury would let banks fail, and therefore - like with Lehman - the only thing really propping them up really was just the confidence of their creditors and their clients. Nevermind, in other words, in the post-LEH world, what the banks were saying about their liquidity facilities or the strengh of their numbers: all that matters is the perception of generalised fear in the system.
Which is all very well and philosophical.
But the real knock-on from Lehman’s collapse and why it really did wreak havoc - in a very direct sense - was the quiet failure of Reserve Primary. When that money market fund collapsed because of defaulting Lehman holdings in its portfolio, other money market funds ran for the hills in a rather spectacular way.
Let the systemic importance of the money market funds not go underestimated. Money market mutuals are the main buyers of commercial paper: short-term debt issued by corporations to fund their activities and ensure solvency on a daily, weekly or monthly basis.
Here’s the catastrophe graph, supplied by the Fed (via Calculated Risk):
This is the spread on A2/P2 Non financial commercial paper over AA commercial paper. Last Thursday’s spread was 280bps.
What the graph shows is an an absolutely unprecedented pullback of buying in the short-term debt markets. Money market mutuals have simply stopped touching CP, even if it’s non-financial. Previous dramatic collapses in CP buying have been limited to that issued by financial companies or asset-backed conduits. Non-financial CP is issued by regular corporations the length and breadth of the US. The kind of collapse the above graph shows marks a sea change in the crisis, with far more profound implications for regular “main street” corporations.
Here, by the way, is where some of that spare money-market money went when it left CP. (Money market fund holdings are restricted to short term debt, certificates of deposit and sovereign debt).
From which point of view it would seem as if the US Treasury made - by its own criteria - a big mistake with Lehman: the $400bn backstop for the money market mutuals only came after Reserve Primary broke the buck. It evidently wasn’t an anticipated consequence.
It’s easy playing counterfactual history of course, there are always myriad possibilities in retrospect. As Salmon notes:
Given volatile and unpredictable markets, the federal regulatory response is also liable to have an element of volatility and unpredictability to it. And that’s not necessarily a bad thing at all.
